Illinois Legislators Mull a Tax on Retirement Income

Today’s edition of the Chicago Tribune contained an article describing Senate President John Cullerton’s suggestion of placing an income tax on retirement income, both from plans covered by the Employee Retirement Income Security Act (“ERISA”), and exempt sources of retirement income (e.g., state pension plans, Social Security, etc.). Placing a greater tax burden on seniors will be a hard sale for legislators. But intelligent debate on the issue cannot even take place unless we educate constituents on the current tax treatment of retirement income, from the day the money is deferred or accrued, until distributed.

First, under Federal income tax laws, any contributions to a tax qualified retirement plan (e.g., 401(k), pension, profit sharing) are excludable from your adjusted gross income, whether you elected to defer the money or your employer makes a contribution to the plan. In addition, voluntary contributions you make to a traditional IRA (as opposed to a Roth IRA) are excluded from your adjusted gross income. These items are not taxed in the year deferred, contributed, or accrued.

Next, the Federal government also allows all money held in a qualified plan or IRA to grow tax-free, meaning there is no income tax paid on the yearly earnings of the account or plan. Finally, the money is subject to income tax upon distribution. There is an additional tax incentive to employers that sponsor a tax qualified plan in that the employer gets to immediately claim the deduction for the compensation deferred or contribution the employer made.

With few adjustments, the Illinois measure of taxable income is largely based on Federal adjusted gross income. So the same amounts that are excluded from Federal adjusted gross income, and thus not taxed, are also excluded from Illinois adjusted gross income and not taxed.

Now fast forward to retirement. Recognizing that some would wish to keep money in a tax-shelter as long as possible, Congress imposes rules on minimum distribution, meaning you must take out a certain amount each year and pay tax on that distribution. I.R.C. § 401(a)(9). Failure to take such a minimum distribution subjects you to a hefty excise tax of an additional 50% of the distribution you were required to receive, but did not. I.R.C. § 4974. After all, Congress is willing to defer income tax receipts, but did not want to forever forego them. While the Federal government does tax distributions from tax qualified retirement plans and accounts, the State of Illinois does not. Essentially, Illinois makes all money saved for retirement (by you or by your employer on your behalf) through a tax qualified vehicle completely income tax-free.